How to Analyze Cash Flow for Residential Investment Properties
The purpose of this article is to provide guidance when doing operating cash flow analysis for residential investment properties. As a reminder it’s important to remember while doing cash flow analysis to be neither too optimistic nor too pessimistic in your estimates. If you’re too optimistic you will make critical errors and if you’re too pessimistic it will deter you from purchasing potentially good investments. Also note positive cash flow shouldn’t be the only requirement when purchasing an investment property, other factors such as location and economic trends are also very important.
To estimate potential gross rental income I would start with websites like padmapper.com that aggregate available rental property from numerous websites. Make sure you’re looking at comparable properties as far as size, location, amenities, etc. It can be helpful when you’re starting out to physically visit a few properties. Secondly, check with your local Realtor for properties currently available and previously rented through the MLS. If your Realtor also rents properties they can be a good source of information. If the property is currently rented and you discover that the rents are significantly below market, you might be looking at a good investment opportunity if the capitalization rate was the basis of seller’s or their agent’s pricing (further due diligence would be required).
After determining your potential gross rental income factor in vacancy to get your potential net rental income. It’s common to have no vacancy for 2-3 years and then have someone move out and have a vacancy for 2-3 months. My usual rule of thumb is 1-month vacancy per year or 8.3% (even if the vacancy rate is lower). If the vacancy rate is higher than this I would probably think twice before buying in that area. National rental vacancy in Canada per CMHC is approximately 3%.
Some other sources of cash inflows include garage rental, parking space rental, and coin laundry.
Your largest cash outflow will likely be your mortgage. Most Financial institutions will finance a maximum of 75 to 80 percent of the appraised property value and the maximum amortization period is usually 25 years (with some exceptions). In most cases I would suggest initially going for the maximum amortization period your lender offers and minimizing your committed monthly payments. Minimizing your committed payments maximizes cash flow and generally makes it easier to qualify for future financing. That said you still want to consider repayment terms and penalties when selecting a mortgage in case you decide to sell or accelerate payments in the future. The TD Bank website has an easy to use mortgage payment calculator.
When making offers on freehold properties it’s prudent to include acquiring satisfactory insurance in the conditions of the purchase offer. Tenants should carry insurance for their contents, but you will need to insure the building and all of its components. Ensure your policy has rental loss insurance in the event of a catastrophic event resulting in an extended vacancy. If you’re purchasing a condo I’d still recommend purchasing insurance as the condo’s insurance policy will likely not cover betterments such as an updated kitchen or bathroom. Consult with an insurance professional and get a quote during the conditional period of your offer to support estimates or assumptions you made initially. Insurance rates can vary widely based on property size, type of construction, and other factors.
The current property taxes can be acquired from the seller through your realtor, and can be verified through the municipality. Many cities have online platforms which make this easy. In Ontario the Municipal Property Assessment Corporation (MPAC) can provide reports for the basis of the assessed value for tax purposes. Look to see if specifications of the property from MPAC match the property in question. If there are significant differences such as discrepancy in square footage (ex. finished basement not included) there is the potential that the tax rate could increase significantly if the property were to be reassessed.
I usually factor in 8-10 percent of rent for on-going maintenance on freehold properties. For condos 5-6 percent of rent is usually sufficient. It’s important to note this does not include capital requirements at time of purchase. For example, if you purchase a property that needs to have the furnace replaced within 2-years this should be included separately in your capital budget at time of purchase (a topic to be discussed separately). Don’t bank you’ll be able to quickly build up a maintenance reserve to cover such costs; as it’s very likely you’ll have other unexpected costs and the furnace might decide to work for only 2-months instead of 2-years.
Property Management: Market rates for property management are usually 8-10 percent. Budget for property management even if you’re doing it yourself, as a good cash flowing property should be able to cover this cost. If you plan on growing your Real Estate portfolio you’ll eventually need to hire someone.
Condo Fees: Include if applicable. A review of a condos reserve fund can reveal if large future increases or special assessments are imminent.
Equipment Rental: Hot Water Tanks, Furnaces, or Air Conditioners are often rented. All rental items should be disclosed to you as the buyer. Generally rental contracts will transfer to the buyer upon close.
Landscaping and Snow Removal: Include if the tenants aren’t or won’t be responsible for it. Like property management still budget for this cost if doing yourself.
Utilities: Include utilities paid by the landlord. Best practice is to have tenants pay for utilities, but in some cases it’s not practical or you’ll be inheriting a lease from the prior owner. Ensure you ask for 2-3 years of bills from the current owner while doing your due diligence. The utility providers may be able to provide information on scheduled rate increases in the future.
Other Financing Costs: Including other ongoing financing costs such as lines of credit or credit card payments.